What are the differences between stocks and bonds?

Stocks Represent Ownership

Stocks are simply shares of ownership in companies. When a company issues shares, it is selling a part of itself in exchange for cash.

Suppose the company passes the startup phase and becomes successful. The owners want to expand, but they cannot do so solely from the income they generate from their operations. Therefore, they turn to the capital markets to obtain more funds.

One way to do this is to divide the company into shares. They can then sell a portion of these shares in the open market in a process known as an initial public offering or IPO.

Bonds Represent Debt

Bonds, on the other hand, are debts. When an entity issues a bond, it is issuing a debt with a promise to pay interest for the use of the money.

The government or company or other entity that needs to raise cash will borrow money in the public market. It will then pay interest on this loan to the investors who lent them the money.

Each bond has a specific value (e.g., $1,000) and pays a coupon to the investors. For example, a $1,000 bond with a 4% coupon will pay $20 to the investor twice a year ($40 annually) until it matures.

At the end of the period, the full principal amount is returned to the investor. If the issuer is unable to make the payment for any reason, the bond will default. This happens very rarely.

Differences for Investors

Each share of stock represents a piece of ownership in the company. This means that the owner shares in the profits and losses of the company, although they are not responsible for its liabilities. A person who invests in stocks can benefit if the company performs very well and its value increases over time.

At the same time, they are exposed to the risk that the company may perform poorly and that the stock price may drop. In the worst-case scenario, the company may file for bankruptcy and disappear entirely.

Individual stocks and the stock market, in general, tend to be on the riskier end of the investment spectrum in terms of their volatility and the potential for investors to lose money in the short term. However, they also tend to provide superior long-term returns. Stocks are preferred by those with a long-term investment horizon and a tolerance for short-term risk.

Bonds do not have the same strong potential for long-term returns as stocks, but they are favored by investors who seek to increase their income. They are also less risky than stocks. While their prices fluctuate in the market – sometimes significantly in the case of high-risk bonds – the vast majority of bonds tend to pay back the full principal amount at maturity, and there is less risk of loss compared to stocks.

Which is Right for You?

Many people invest in both stocks and bonds to diversify their investments. The decision on the right mix of stocks and bonds in your portfolio depends on your investment time horizon, risk tolerance, and investment goals. Stocks and bonds typically do not fluctuate at the same time.

If seeing the stock price drop quickly causes you to panic, or if you are close to retirement and may need the money soon, relying more on bonds in your portfolio may be the best choice for you.

If you are a young investor with plenty of time, you could benefit from a weak market. You can buy stocks after their prices drop and sell them when prices rise again.

Everyone has their own financial goals. Keep these in mind when choosing the investments you want to make.

Frequently Asked Questions (FAQs)

What is the recommended percentage of stocks versus bonds in my portfolio?

It varies

The recommended ratio of stocks to bonds in your portfolio depends on your circumstances. If you started investing when you were young, you could allocate a larger percentage of stocks in your portfolio due to long-term returns, which will mitigate the risks of stock volatility. As you approach retirement, you will want to gradually shift towards more bonds to counteract the increasing short-term risk.

What happens to stocks and bonds when a company goes bankrupt?

If a company files for bankruptcy, it must pay off its debts before paying its shareholders. This means that bondholders are in a better position to recover money compared to investors when the company is in trouble.

How can I buy stocks and bonds?

To buy stocks, you need to set up a brokerage account, fund it, and then start trading. You can do this online, through a securities broker, or directly from companies. Bonds typically require a larger minimum investment and can be purchased through a broker, a mutual fund, or directly from the U.S. government.

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Sources:

The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.

Investor.gov. “Stocks.”

Investor.gov. “Investor Bulletin: Investing in an IPO.”

Investor.gov. “Bonds.”

Investor.gov. “Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing.”

Investor.gov. “Introduction to Investing.”

Fidelity. “When Bonds Go Bad.”

Source: https://www.thebalancemoney.com/the-difference-between-stocks-and-bonds-417069